Weblog of Joe Ross, Trading Educator and Trader for over 5 Decades

I recently received this letter, and thought you might like to see how another currency trader approaches the markets.

“I approach the markets as a game of probabilities. As far as I’m concerned, that’s the only way to navigate the currency markets.

“What I mean by a game of probabilities is this: I do as much as I can when figuring my fundamental and technical analysis. I read and study all I can. And I do this with discipline, focus, and consistency. I do this to try to gain an edge.

“But I know there is never such thing as 100% certainty. You can never have enough brain power or computing power to harness the mind of the market. It’s not because the computing power isn’t available – it is. It’s because the players in the market do not make “rational” decisions all the time.

“When push comes to shove, the big moves in the market are driven by good old fear and greed, the base human emotions. The fear and greed and irrationality of millions of players can’t be modeled with much degree of certainty. That’s a problem for economists and experts who believe they can create some type of Holy Grail model to forecast price action. They simply don’t have the mathematics available yet to get their arms around irrationality in a modeling scenario. And there is no reason to think they’ll be able to factor in human emotions anytime soon.

“‘If you are going to use probability to model a financial market, you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising – far greater and more damaging than the mild variations of orthodox finance,’” writes Benoit Mandelbrot, The Misbehavior of Markets.
Note: Benoit Mandelbrot is the person who created fractal mathematics. He is a brilliant man, to say the least. And he has been shunned to a degree because he has never bought into financial orthodoxy that starts out with ‘the rational man.’

“Bingo! ‘Real markets are wild.’ The massive volatility we’ve already witnessed in the currency market, after only the days of trading this year, prove Mandelbrot right once again.

“So, does this mean we should be defeatist and believe we can never win? Absolutely not! But it does mean you need to develop a reliable system to help you recognize when it makes sense to trade. Or in other words, you need a system that pushes the probability of success in your favor. Here’s what I do to help make currency trading decisions.

“My methodology is a three-step approach:

“1) I watch the key macro themes around the world. I continually ask: where is the money flowing around the globe? What countries or regions are hot? What assets are investments flowing into? Is it stocks or bonds or commodities, or some combination of these? Why are assets flowing in those particular investments? Is it interest rates or economic growth, or geopolitics? These are the type of questions you need to ask in order to develop an understanding of the macro themes.

“2) I look at the technical pictures-charts! First I look at the weekly trends, then daily, then intraday (if it is a very short-term trade). Keep in mind, the tighter the timeframe you analyze on a chart, the more random the movements may be. In other words, these short-term movements you see could be just noise, so you can’t always try to match your broad macro themes to the daily charts. Use your weekly charts to confirm your macro view. Charts are especially helpful when you’re looking at intermarket relationships. For example, you can see if there’s a clear relationship between gold and the U.S. dollar. Often those two move almost as a mirror image of one another. When gold goes up, the dollar goes down, and visa versa. I continuously compare commodities, bonds, and equities against the move of the dollar to see if there is a relationship. Noticing these relationships can definitely give you an edge in the markets.

“3) I try to judge what the sentiment is in the markets. I ask myself, are too many players doing the same thing? This is extremely important, because you don’t want to be late to the party when investing. When everyone has bought, there is no one left to support prices, and they can fall of their own weight. I also look at surveys, open interest, and volume to gauge sentiment.

“Yes, it’s a lot of work. But this is my system that has evolved over the years and suits me well. I’m confident that if I do my homework and apply my system consistently, I’ll win over time. And the same system can work for you too.”

Some people like facts and figures; others prefer trusting their intuition and looking for artistic expression in the realm of trading. The trading profession is big enough for all kinds of traders, though. There isn’t one right way to trade, but the trick is to figure out what you are like and to match your trading style to your personality. Take the data-driven trader, for example. At an extreme, the data driven trader looks for consistency and attempts to find “rules” and conventional wisdom to guide trading decisions. For some data-driven traders, a major preoccupation is to study historical data and back-test ideas until a good fit is discovered. Other data-driven traders enjoy spending their nights scouring reports for a valuable tidbit of information that will give them an edge. If you are the kind of trader that enjoys getting caught up in the details, using this affinity to your advantage is the best way to profit from the markets.

I often write about mindset, attitudes, psychological hangups and emotional problems that plague traders. The following is from a friend on mine, Noman Hallett, who has delved deeply into such matters.

“It occupies a chapter in just about every trading book ever written. It’s been preached by every lecturing market guru since the Aden Sisters danced to the music of the gold market.

“Go ahead and hire a personal trading coach and likely the second thing he or she will utter will be these chosen words (right after “Futures trading is speculative and only risk capital should be used.”)… and those words are, “Limit your losses and let your winners run”.

“OK. We’ve been told.

“But you didn’t have to tell us. It makes perfect sense. ‘On a roll’… ‘Go with the flow’… ‘Ride the wave’… ‘Get out while the getting’s good’… we’ve heard both sides of those golden words massaged in numerous different phrases. We get it.

“During my trading and coaching days, I would re-visit students that I trained weeks or months previously and low and behold I would discover that many of them were actually doing the opposite… letting their losses run and limiting their gains.

“After a while I wasn’t surprised… I would go into a refresher visit EXPECTING to see ‘limit/run rule’ repeatedly ignored.

“I would ask the students ‘Why?’… There were many different stories but one main theme… all the traders, in some way, had gotten out of emotional control.

“During their trainings, I had made sure that they had done extensive back-testing on their systems and I did that because I knew that the more they tested and saw that their system would have been successful, the more they would TRUST in the system and have the strength the follow its signals, especially through rough periods.

“Apparently, simply back-testing, and seeing ‘would-have-been’ results wasn’t enough to keep these traders in emotional control. What I had been missing was that these traders were taking the losing PERSONALLY!

“These new traders had been seeing losing trades as reasons to let negative thoughts into their heads. A loss would mean that all the articles they read about ‘gambling’ traders may be true. All the family accusations that they were crazy traders … well, that could have some merit!

“This kind of negative thinking (as well as other forms of related negative thinking) makes it so you don’t want to take a loss. If you take a loss, maybe you’re that much closer to that idiot trader that you’ve been accused of.

“So you enter a trade (after, say, coming off a losing trade) and it starts to go south. As the market heads for your stop, you start looking around at the news, or a chart of a ‘sister’ market that’s showing strength, searching for an excuse to make it OK to lift your stop.

Found it.

“… Cancel the trade.”

Stop Canceled.

If the market comes back, you’ll be the smart guy or gal that made the right move and turned a loser into a winner. What you really just did, however, is turn a potential winner into a potential loser.. YOU. You may have had a winning trade, but you will lose in the end. You learned the wrong lesson.

It’s not about YOU. It’s about THE MARKET. If you don’t take your emotions out of it, you don’t have a shot. You must see yourself as a trader not someone who is becoming a trader.

There’s very little room for mistakes in your trading. Leverage makes sure of that.
If you are going to play in the Big League, you have to do act and do what the Big Leaguers do… right from the beginning.

Do all you practicing on the paper-trading playing field. Once you put your money up, you either do what your tested system tell you to do or pick a different profession.

If you’re not training mentally, you’re not giving yourself the best chance laughing in the face of your relatives!

Is trading easy or hard? To the outside observer, trading seems easy enough. You merely pick what you want to trade, bet it will go up or down, execute a trade and see what happens. What’s the big deal? If it were that easy, however, everyone would be doing it and making millions. Unfortunately, it is not that easy, especially in a sideways market or one that fluctuates wildly. In a strong bull market like we saw during the dot-com boom, amateur traders merely opened an online account and watched their account balances balloon. It all changed in 2000, though. We’ve seen a taste of “the good old days” in the past month, but even when the masses are interested and prices go up, trading is not easy. You have to work at it, and hard, to make profits across a series of trades.

Successful trading is part financial resources, part trading strategy, and part psychology. Suppose that you had a simple trading strategy. You might decide to find markets that temporarily went down on general weak economic news, but by all indications, the markets should increase when clearer heads prevail. You look at all the information, and decide to develop a trading method based on “seller’s remorse.” That is, you anticipate that there will be those investors who sold in a panic on weak economic news and will buy back when they realize that the markets were still good buys. But there’s more to it than good trading strategy. You must also decide how much capital you will devote to the strategy. On any one trade, you might risk 2-3%, but not all of your picks will go up in the way you had planned. Trading is also part mathematics. Some of your trades will come through, but others will not. You have to decide how many trades you will make and how much you will risk. And if you have the stomach to risk that much.

If you have relatively low financial resources, taking a 20% risk may be hard to handle. You may feel it would be a disaster if your approach did not realize a substantial profit. Psychologically, taking the risk can be anxiety provoking to say the least. A jumble of thoughts may race through your mind as you execute the trades, and monitor them. As you anxiously await the outcome, you may barely be able to think clearly as your emotions overpower you.

What do you do if you can’t tolerate risk? An obvious solution is to simply take less of a risk. You may not want to make all 10 trades, for example. Instead, look for two or three of the 10 that are the most likely to produce a profit. You do not stand to make as much, but you are not likely to lose as much either. And if you have trouble tolerating risk, the piece of mind you get instead will probably be worth more than the profits you could have made, considering the financial and psychological risks it would require. What are the long-term consequences? On the one hand, it may seem that you will never make huge profits in the markets if you are not willing to take risks. After all, seasoned, professional traders put on big trades and it doesn’t bother them. But you must decide if taking such big risks would be in your best interests. And until you are confident that you can make profits in market to market, you might want to hone your trading skills before taking big risks.

Don’t downplay the importance of risk management. There are financial and psychological benefits for limiting risks. A hard reality of trading is that there are few foolproof trading strategies. Even the most reliable strategy is bound to fail eventually. Market conditions frequently change, and when they do, your strategies must be changed also. The trouble is that you don’t know when a strategy will fail or when it will not beforehand. Your best defense against the sporadic changes in market conditions is to limit your risk. If you limit your risk, you’ll be able to survive the learning curve, and eventually, become one of the select few who profits big from trading the markets.

When your money is on the line, it’s natural to want to make every effort to protect yourself. You want to account for every possible adverse event that may thwart your trading plan, but you don’t want to overdo it. Some traders have difficulty making a distinction between sound decision making and an obsessive need for perfection. Rather than acting decisively, they have an insatiable need to seek out certainty and security. One of the ways they seek out certainty is to make up superstitious rules to follow. They continuously search for rules that identify the “right” and “perfect” way to trade, but many times, there are no infallible rules that guarantee success. Traders must live with uncertainty and accept the fact that there are times when you have to go with your gut instinct and see what happens. But the obsessive-compulsive trader is overly concerned with trading perfectly. It is as if a little voice in the back of their mind nags them, and threatens to punish them when the “right” rules are not identified and followed unconditionally. They may waste time trying to find the “right” indicator or the “right” trade setup. And even when they see it, they have a strong need to want everything to be perfect. Because if they don’t, they are certain that they will pay for it. Perfectionism can be a curse when trading the markets, however. It’s essential that you strive for high standards, but not get so obsessive with perfectionism that you get stuck.

Trading rectangular block, i.e. ledges, or sideways chart patterns is a solid market trading approach so long as the breakout is not a false breakout. A legitimate breakout should not retrace to 50% of the block pattern range, as the most profitable trades never retrace below the breakout price. If the low of the daily breakout bar is broken on a closing basis, it was a false breakout and you need to exit the trade as soon as possible. A false breakout requires another breakout bar above the most recent high before a long entry —
vice-versa for a short entry. Wait for a breakout to occur, then buy (sell) the next breakout of the first correction.

Many professional traders say that a breakout from consolidation is not real until you have a bar which is entirely clear of the consolidation area. That means every part of a price bar must no longer be in touch with any price in what were the consolidation parameters. If the breakout is to the downside, the high of the true breakout bar must be lower than the lowest bar of the consolidation. If the breakout is to the upside, the low of the true breakout bar must be higher than the highest high of the consolidation.

There may be other ways to define a breakout from consolidation, but the ones above are the ones I know and use.

In the trading world, the “Market Wizards” are often elevated to the status of idols. Why not? They have accomplished relatively rare feats. Consider Tom Baldwin, for example, he took what Jack Schwager called a “skimpy capital base” and turned it into a fortune. His “fearless” approach to the markets allowed him to trade aggressively. These tales of success can be inspiring, but they can also create unrealistic expectations. You may start to believe that you need to be a natural born trader to profit in the markets. But successful trading is often a matter of persistence, and it is hard to persist if you believe that trading requires special talents. It is more useful to work under the assumption that profitable trading can be learned. That’s not to say that anyone can learn to trade, but if you are relatively intelligent, confident in your ability to succeed, and persist long enough, you can learn how to master the markets. It’s all a matter of taking trading seriously, setting specific goals, and following a well-thought-out trading plan.

Psychologists have found that many people get fed up and decide to quit when they make broad generalizations about their abilities after a setback. Rather than focus on specific deficits, they view their flaws as very general, enduring, and only about them. They think they aren’t intelligent enough or they believe they don’t have the right personality to trade. Although this may be somewhat true, it is not useful to think this way. It’s much more adaptive to be specific about what you are doing wrong.

Consider the plight of one trader we know. He is upset because he lost money on a trade. At about 11:00 this morning he noticed that a market went up $1 since the open. He bought, but the price went down just as fast as it went up. He decided to cut his losses. What should Jack do at this point? First, let’s consider what he shouldn’t do: He should not attribute his loss to an enduring inability to trade. He should not think pessimistic thoughts like, “I’ll never learn to trade profitability. I just don’t have enough talent.” What he should do is identify where he has specific problems with his approach to trading. For example, he did not have a detailed trading plan. In addition, he did not study the market closely enough before trading it. By identifying specific problems, rather than making global statements about his abilities, he can make a specific plan for improving his method. He can learn to trade better. He can develop more detailed trading plans, and be determined to follow them.

Many people jump to the conclusion that their performance is closely linked to innate abilities. But oftentimes, the more you practice trading, the better you will become at it. Don’t be afraid to identify specifically what you are doing wrong. The faster you do so, the faster you will improve, and the faster you will take home the profits you desire.

Get ready for the latest attack on the U.S. dollar, courtesy of our Congress and the Administration.

On March 23rd, President Obama signed into law a sweeping rewrite of U.S. health-care policy.

Initially, at first glance, it seems good.

It supposedly gives an additional 32 million Americans access to basic health insurance by 2019.

One thing is certain. It’s the biggest change to the American health system since Medicare was enacted in 1965.

However, it seems there are a few unintended consequences coming from this groundbreaking bill.

First of all, this healthcare revolution will cost $938 billion. That’s almost $1 trillion on top of the $12.67 trillion the U.S. already owes.

Now, if you ask the average person where that’s going to come from, they don’t know and probably don’t care.

Keep in mind that the government’s income comes from the taxes that we all pay. So if they’ve got greater expenses, guess what that means?

Greater taxation…and not just for the wealthy either (even though that’s the way Obama pitched his plan to middle-income America who couldn’t care less if a few wealthy fat-cats pick up the bills). Most of these health care changes won’t even start to take effect until 2014. So we’ve got a while before they start taxing us, right?!? Wrong!

One New Tax Went into Effect
As Soon As Obama Signed the Bill!

Many increased costs will kick in next year. But some taxes have already started as a result of this! Since March 23rd, any American who uses a public tanning bed has had to fork over 10% tax for the privilege.

Obamacare Will Create 17,000 Jobs…
(at the IRS)

However, there will be one bright spot. Yes, one segment of our economy will be robust. Which is it? It’s the Internal Revenue Service. They are hiring 17,000 new agents.

The IRS is going to need that many more bodies to help them rake in all of the additional tax money that Obama needs to pay for this.

There’s more. Companies with 50 or more employees will have to pay a fine if their workers receive government-subsidized coverage.

Next on the “Obamacare loser list” is the wealthy.

Maybe you’re on that list. Maybe you’re not. But regardless, this new “tax the rich” policy still affects you. Here’s why.

As you may have noticed, poor people don’t hire employees! No, it’s “wealthy” entrepreneurs who need more workers. If you tax these rich business owners harder, they won’t have the cash they need to continue hiring.

Obama is not wasting any time.

Is it true that only wealthy Americans use tanning beds? Plenty of average people use tanning beds, especially in the dead of winter. That’s just one example of how we’re all picking up the tab for this new health care bill.

But once these changes start, you can bet that employers will initiate more layoffs, and will be inclined to hire fewer people. Why?

Companies with more than 200 workers will be required to automatically enroll all their employees in whatever insurance plan they offer. When those corporations have to maintain these higher costs, they’ll make cuts in payroll in order to preserve their profit margins.

The “rich” make about $200,000 – $250,000 a year, and they’re about to pay 0.9% more for Medicare Payroll Taxes.

By the way, calling someone who makes $200,000 a year “rich” is fair only if you live in a place with a low cost of living. Tell a Californian he’s “rich” because he makes $200,000, and he’ll laugh at you!

Also, these “rich people” will have an additional tax of 3.8% on investment income like dividends and capital gains beginning in 2013.

Have I mentioneed all of the “losers?” No! I won’t go into great detail on the rest, but here are a few other groups that will get hammered:

Believe it or not, within the health care reform, banks will lose the government backing/guarantees on education loans. So schools will have to go directly to the Department of Education for funding.

“The Insured” will also lose out. Experts say we could see “double digit” increases in some places like California (and that’s just for people who make above $88,000 a year).

We’ll All Be Paying for an Expensive
Program

When you put all the pieces of this together, you’re going to see higher taxes coming (and not just on the rich), higher unemployment and lower new employed rates, increased health care costs, etc.

All of this will be yet one more weight and hurdle placed upon corporate America, and many, if not all, of its citizens.

If you think companies are struggling now, wait until all of this comes to a head in a few years. You haven’t seen anything yet!

In the Long Run, “Obamacare”
Spells Trouble for the U.S. Dollar!

This will all take a huge toll on the U.S. economy. It will likely make our economy even more sluggish.

Consider: if consumers and corporations are taxed more and have higher costs, then they are not going to spend as much. When spending is restrained, the economy struggles.

So this long-term “ankle weight” that’s being placed upon the U.S. economy will end up eventually taking a long-term toll on the dollar as well.

It probably won’t affect the dollar immediately.

In fact, in the short run, if stocks, bonds, or commodities were to fall, it would actually help the dollar for now. But over longer periods of time, there’s no way that the dollar can prosper when the entire nation is hurting from the extra yoke placed on both consumers and businesses.

So take this as yet one more warning to get yourself out of the dollar! Use rallies in the dollar to get some long-term positions in foreign currencies and “hard currencies” like gold and silver.

When learning any new skill, you need to find the right balance between pushing yourself to the limits and setting realistic expectations and goals. But whatever approach you take, you must work with what you’ve got. You must identify your natural inclinations and work around them. This is especially a challenge for trading. Generally, there are two basic types of novice traders: the fearful and the overconfident. Neither type achieves long-term consistent success easily. The fearful are reluctant to put on trades. They are easily frightened. Upon encountering the slightest signal of the trade going against them, they bail out. They don’t make money in the long run. The overconfident, in stark contrast, don’t show enough caution. They aren’t afraid to put large sums of their trading capital on the line, even when their methods are questionable. They have a gung-ho attitude. They may stumble upon early success, but usually fail in the end. Fortunately, these are two extremes, with most traders. The rest of us probably fall somewhere in-between.

It’s useful to be a little fearful, but not too fearful. At least the fearful are sufficiently risk averse that they show enough skepticism to protect their interests. Some people are overly fearful, however. Their central nervous system is easily “activated” and when facing risk, it’s unbearable. Traders with this kind of personality style are afraid to put on big trades, and while they are in a trade, they feel uneasy as they wait for the trade to reach the profit objective. Because they panic a little too easily, they sometimes have trouble sticking with their trading plan. They hesitate upon entering a trade, and may exit at the wrong time. Although it’s hard for the extremely risk averse to trade in a calm, objective, and effortless style, it doesn’t mean that they need to give up trading. Every trader just needs to come up with ways to work around their limitations. Even some professional traders are reluctant to enter a trade.

The overconfident, trader doesn’t show enough risk aversion. Overconfident traders think they have more skills than they actually do, and tend to put on trades without adequate preparation. There are many kinds of overconfident traders. For some overconfident traders, their trading behavior was improperly reinforced. For example, they may have learned to trade in a bull market where prices seemed to go essentially straight up. Or their first few trades may have made big profits, purely by chance, and they gained a sense of reassurance and a false sense of confidence because of this run of early luck. Others, ironically, only appear overconfident, but actually, they lack confidence, and just put on trade after trade to hide their feelings of inadequacy. Whatever the reasons, it’s vital for survival to admit that as a novice trader, you do not yet have the requisite trading skills to trade with a solid sense of self-confidence. You should be a little skeptical and take proper precautions.

Whether you lean toward the fearful trader or the overconfident trader, it’s useful to identify where you stand on this continuum and take active steps to work around your personality. Relax, take it easy, and give yourself the time you need to master the markets. You’ll feel better and trade at your best.

Cultivating discipline and self-control is vital for consistent and profitable trading. You implement proven trading strategies, over and over, so that across a series of trades, the strategies work enough to produce an overall profit. It’s like making shot after shot on the basketball court so as to accumulate a winning number of points. The more shots you take, the more likely you will amass points. But the winning player is the person who first develops the skill to make the shot consistently, so that at every possible opportunity, the ball is likely to go through the basket. To a great extent, consistency is the key. If the player uses one approach one time and a different approach at another time, performance is haphazard.

It’s the same for trading. One must trade consistently, following a specific trading plan on each and every single trade. This allows the law of averages to work in your favor, so that across the series of trades, you will make an overall profit. If you follow the plan sometimes and abandon it at other times, you throw off the probabilities. Suppose you used a strategy that had a track record of 80%. Under the best-case scenario, you could only expect to win 80% of the time. But since history doesn’t always repeat itself, it’s likely that you will win less than 80% of the time. If you don’t execute the trading strategy the same way each time, you will decrease your winning odds. And fewer winning trades may mean an overall loss. That’s why discipline and self-control are so important.

With discipline and self-control comes profitability. Don’t let unjustified wins interfere with your ability to maintain discipline and self-control. Follow your trading plan, and reinforce the idea that if you follow your plan, you will end up with profits in the long run. If you abandon your trading plan, and get an unjustified win, you may feel good in the short term, but you’ll pay a long term price when it comes to your ability to maintain self-control. So clearly define your trades and your trading plan (discipline), and stick with your trading plan (self-control). The justified wins you receive from following your plan with help you develop an unwavering pattern of disciplined and controlled trading.